How to Measure Operational Risk

What types of risks does your company face each day?  With every action your business takes, there’s a chance that you might lose money. One of the main risks associated with daily activities is called operating, or operational risk. Yet what is operational risk, how is it defined, and how is it measured? We’ll explore these questions with our guide below.

What is operational risk?

Operational risk, also called operating risk, refers to all the uncertainties that businesses face in their day-to-day activities. The risk exists because of the fixed costs required to keep production up and running. While sales risk relates to the uncertainty that goods and services will be sold at a profit, operational risk is more concerned with cost structure and operating income.

When any systems or internal procedures break down, production slows accordingly, and it becomes more difficult to earn a profit. No matter how much you produce, your business will still need to pay its fixed costs. This leads to an element of risk because there’s the chance that you won’t generate enough sales to pay associated costs.

How to measure operational risk

The more fixed costs involved in a company’s operations, the higher its operating risk will be. A company can reduce its variable costs because they’re dependent on production levels, but fixed costs are independent from production and revenue.

To measure operational risk, it’s important to understand why fixed costs have such an impact. A high level of fixed costs makes it more difficult for a company to adapt to sudden breakdowns in operations, or fluctuations in sales figures. A significant drop in sales will lead to a decrease in profits, but the high level of fixed costs remains the same due to operations.

Keeping this in mind, how do you measure operational risk? One concept that helps is using elasticity measurements, including the degree of operating leverage (DOL). This measures how sensitive your business’s operating income is to any variations in production or units sold.

The formula for degree of operating leverage is:

What would this look like in operational risk examples? Consider that Company ABC experienced a 6% increase in its operating income for every 2% increase in units sold. This would give it a degree of operating leverage of 3. The closer that operating income gets to zero in any operational risk examples, the more sensitive it is, indicating a higher level of risk.

Financial risk vs operational risk

There are many types of risk involved in business, so what is the difference between financial risk vs operational risk? In a broad sense, operational risk can be listed as a type of financial risk. Financial risks include any risk of losing money, whether it’s due to operational breakdowns or other causes.

In the context of corporate finance, financial risk can specifically refer to the risk involved with defaulting on financial obligations. This inability to meet its obligations might be due to problems with operations or fixed costs, but it’s more related to debt financing and leverage. By contrast, operational risk is more concerned with the day-to-day costs of earning profit.

Operational risk management

It’s impossible to completely eliminate operational risk. All businesses have fixed costs associated with production. You can find ways to reduce your operating costs, which in turn reduces risk. Generally, it’s best to strike a balance when looking at operational risk management. Think first about your industry. Some industries will need to have higher levels of fixed cost than others. You should also consider the general financial health of your business. Is your balance sheet looking promising or is there a wide margin between liabilities and assets?

Finally, remember that with higher operational risk comes the potential for both higher losses and profits. If you’re willing to take on more risk, it could pay off in the long run with higher profits over time.

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